Asset price bubble

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An asset price bubble is characterised by a surge in prices that raises expectations of further increases that generate a succession increases until confidence falters, the bubble "bursts", and prices rapidly revert to an objectively-based level. That is the pattern of events which has characterised hundreds of episodes from the "South Sea Bubble" of the 17th century to the housing bubbles of the early 21st century. In many instance their effects have been transitory and localised, but some have caused extensive economic damage.

Contents

The causes of bubbles

Herding

Psychological experiments have demonstrated an inherent human tendency to unconscious herding, and there is evidence to suggest that herding is characteristic of the conduct of both institutional and stock market operators on the stock exchange [1]. That conduct may be considered irrational but it has been shown that herding can be rational and that rational herding can generate reinforcing information cascades[2]. Information cascades have been observed in other contexts , and the herding behaviour with which they are associated has characterised the conduct of the subjects of many experimental studies of human behaviour[3]. One surge in share prices has been termed "irrational exuberance"[4], and that term has since been applied to other episodes, but whether the word "irrational" is really justified turns on the choice of interpretation.

Herding behaviour has often been attributed to ill-informed noise traders, but John Maynard Keynes, himself a successful investor, has attributed it also to professional investors:

"professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view." [5]

Keynes' insight was supported by an NBER paper by David Scharfstein and others, which demonstrates by means of a model that herding can occur even if all the investors act rationally [6], and by another model created by Andrei Shleifer, showing the effects of introducing noise traders [7].
The routine use of stop-loss orders (that probably contributes strongly to the speed of decline when a stock exchange bubble bursts, and is itself a form of herding behaviour), is widely practised by professional investors [8].

The Minsky hypothesis

According to Minsky's financial instability hypothesis[9] a bubble is the result of a three-phase sequence of transactions:

"hedge transactions", that characterise the cautious conduct of the banks following an economic downturn, when credit is made available only to those who demonstrate their capacity to make repayments from well-established cash flows;

"speculative transactions" that tend to follow as confidence returns, and credit is also offered in the expectation of repayments from expected cash flows;

"Ponzi transactions", that take place in the course of the ensuing boom, and which provide credit in the hope that repayments would be made from currently unknown sources that may become available as the boom develops.

The Shin hypothesis

Typical consequences

Frederic Mishkin has identified two categories of asset-price bubble[11]:-

"credit boom bubbles", in which expectations of increases in the price of some assets, lead investors to borrow against the security of those assets, increasing their demand, and enabling them to use the assets to obtain more credit and increase their leverage, in a positive feedback loop which continues until the bubble bursts. The losses then suffered lead to deleveraging, a credit crunch, reductions in business investment and consumer expenditure, and a fall in economic activity.

"pure irrational exuberance bubbles", not involving leveraging and deleveraging, which do not result in a credit crunch or cause any substantial reduction in economic activity.

The house price bubble that led to the crash of 2008 was an example of the former category, and the relatively benign "dot.com" bubble was an example of the second category.

Leading indicators

Asset price bubbles are easy to identify after they have burst, but difficult to distinguish before that happens. In the October 2009 World Economic Outlook, IMF economists warn that "even the best leading indicators of asset price busts are imperfect"[12].